Overnight Sentiment: Europe Back In Focus

After briefly attempting to stage a rise in the early overnight session, the EUR has since resumed its lower glidepath (something which Germany's export-focused economy and the only realy economic driver in Europe desperately needs: after all Europe is the only entity in the world whose central bank is working to promote a stronger currency) to the 1.2900 support, as once again Europe comes back into focus, exposing all its warts, scars and boils in perfect 1080HD resolution. Among the key events were a Spanish €4.00 billion bill sale as well as an Italian €3.94 billion 2 year bond sale, which despite selling at the maximum of the intended range, showed far less investor demand than on recent occasions, a development which Rabobank said is to be expected as the "Draghi effect" wanes, and once again Europe is left to its own devices. "The longer Spain delays on requesting bailout, the more the improvement in sentiment following Draghi’s pledge to save euro is likely to unwind" Richard McGuire, fixed income strategist at Rabobank, writes in client note. "Unraveling of “Draghi effect” may accelerate, with possible Moody’s downgrade this week and lack of progress at Oct. 8 Eurogroup summit." Other events out of Europe include the ongoing attempts in Spain to package lots of trash under the rug (see: Spanish Bad Bank Risks Investor Conflict With Stressed Lenders), the realization that the Swiss National Bank instead of continuing to exchange EUR for AUD, bought €80 billion of core debt according to S&P, the print of Italy's September consumer confidence which held near 15-Year lows, a French industrial sentiment which held near Two-Year lows, and so on. Greece too continues to make noises but it seems that the little country is being ignored by everyone. Catalonia's separatist tensions however are getting louder after the Barcelona province did not get the unconditional bailout it demanded (as we wrote yesterday).

However, perhaps the biggest news of the day came from China where in addition to Taiwan boats being sprayed by water Japanese water cannon to cool nationalist tensions, 1 year repo rates rose for a 7th day, the longest since March, while 7 day repos surged by 19 bps to 4.70%, on continued liquidity concerns. Increasingly the country's banks are demanding more cash from the PBOC however with food prices already set to soar, the central bank has no choice but to continue with the daily reverse repo band aid operations it has been engaging in for months. At some point this tension will come to a climax, and then we will get rumors that Spain is bailing out Spain.

A quick glance at markets where they stood most recently:

Spanish 10Yr yield up 7bps to 5.75%

Italian 10Yr yield up 6bps to 5.11%

U.K. 10Yr yield down 4bps to 1.78%

German 10Yr yield down 4bps to 1.52%

Bund future up 0.33% to 140.87

BTP future down 0.49% to 105.18

Euro down 0.17% to $1.2909

Dollar Index up 0.11% to 79.6

Sterling spot up 0.09% to $1.6234

1Yr euro cross currency basis swap unchanged at -25bps

Stoxx 600 down 0.04% to 274.6

For more perspective on the overnight session we go to DB's Jim Reid:

Looking at the overnight action, markets are trading broadly weaker with the Hang Seng and KOSPI down 0.3% and 0.4% respectively. In China the Shanghai Composite is about 0.4% lower as yesterday’s late rally failed to follow through. Meanwhile, China’s industry and information technology minister said more small companies in China are halting all or half of their production due to narrowing profit margins.

We will get further updates on Chinese corporate profitability on Thursday with the monthly industrial profits report. Indian equities (-0.1%) are outperforming as sentiment towards the country continue to improve on the recently announced reform measures.

Back in Europe, as the world waits with bated breath for Rajoy to act in formally requesting EU aid there is very little sign to suggest that Spain will ask for official aid anytime soon. Reuters reported yesterday that EU officials do not expect him to seek an assistance program until after a key regional election in Rajoy's home state of Galicia on October 21st. It also seems that members of Merkel’s coalition are growing impatient with the status quo. CDU Finance spokesman Michel Meister said that Rajoy "...must spell out what the situation is. The fact he's not doing so shows Rajoy evidently has a communications problem. If he needs help he must say so." Adding to the pressure EU’s Van Rompuy yesterday warned against a “tendency of losing the sense of urgency”. Having said all this Spanish bonds rallied with the 10yr down by 8bp on the day. Don't expect Rajoy to be in a rush to ask for help. The stand off will continue and we think the market might start to lose a little patience after this week's big announcements.

On the ESM leverage proposal, German Finance Ministry spokesman Kotthaus yesterday sought to play down the Der Spiegel story over the weekend. He said that leveraging the ESM is possible but to prescribe a EU2trillion headline (as per Der Spiegel) is “illusory”. Kotthaus conceded that EU officials were discussing ESM leverage mechanisms, and the bailout fund will "receive and use the same tools as its predecessor, the EFSF, nothing more and nothing less". In terms of the IFO print, the Expectations index came in at 93.2 (vs 95.0 expected) while the Business Climate index came in at 101.4 (vs 102.5). Both indices have now recorded five consecutive monthly declines. Our German economists point out that declines come despite the favourable constitutional court ruling and the ECB's OMT announcements during the month, and subsequently the risks of a quarter with negative growth in H2 have increased further.

More on Europe, IMF’s Lagarde yesterday hinted that a Greek restructuring may be needed after commenting that Greece faces a financing gap that won’t be solved by budget savings alone. She added that the IMF is targeting a long-term sustainable debt/GDP ratio of 120% and that Greece’s debt “will have to be addressed as part of the equation”. In its monthly bulletin the Bundesbank said that the IMF was taking on excessive risks by “transforming itself from a (temporary) liquidity-providing mechanism into a lending institution”. The article goes on to say that “such a transformation would neither accord with the legal and institutional provisions of the IMF agreement” (Financial Times).

Elsewhere, according to Reuters who cites several bank executives, Spain's bad bank will acquire NPLs from Spanish banks at only a small discount to book value in order to prevent the recognition of losses at banks. The average discount on original book values will be 45- 50%, obtained by applying a 5-10% discount on written down values (Reuters). Portuguese PM Coelho dropped a plan to increase social security contributions from workers following recent protests, instead favouring income tax hikes and wage cuts to meet budget targets.

It looks as though the improvement in Greece's exports has stopped. Take a look at the numbers.

Greece’s Balance of Payments

Greece’s statistics office has released her latest trade figures for today and they show a worrying sign. The improvement in her exports seems to have stopped as July 2012 showed a 1.3% fall on July 2011 in value terms. As there is positive inflation this is a larger fall in real terms. Monthly figures can be very erratic so care is needed but it looks as though Greece’e export boom is slowing as for 2012 so far her exports had increased by 6.1%. As one thing that IMF style programmes can usually achieve is balance of trade improvements this is very worrying if it should continue.

Also there is food for thought for one of the supposed benefits of being in the Euro as Greece’s trade performance improvement in 2012 so far is much more marked with nations with whom she does not share a common currency!

"Spain’s [...] Deputy Prime Minister Soraya Saenz de Santamaria said the country needs to know how much the European Central Bank will spend on debt purchases before it decides whether to ask for a bailout."